Reflections

Are you Risk Averse or Loss Averse?

The S&P 500 Index dropped 19% in the Summer of 2011, an instance of a market correction of 15% or more. You may remember it. Investors across the country were dealing with high unemployment and the Congressional clumsiness of the debt-ceiling crisis. These problems were universal for all investors, yet how that 19% correction made you feel was entirely specific to your personal circumstances.

To see why, let’s take a look at a hypothetical example. Say in 2011 you were several years into your career and just beginning to see your savings account accumulate. You had $100,000; when we asked you during our initial conversation what you would do if the market dropped 20% you confidently replied: “do nothing or buy more.” Now the market falls 20% and you’ve lost $20,000 (in practice you’ve lost less, because we have you diversified and not fully exposed to the S&P 500, but for simplicity’s sake stay with us here). Well $20,000 is certainly a lot of money, and you don’t feel great about the short term loss; but we review your long term goals, you mention that $20,000 could be made up with a nice year-end bonus, and you remain invested and stay on plan.

Here’s a look at another case.You are in your late 50’s and approaching retirement. Through years of hard work and investing you have built a portfolio of $4,000,000. An experienced investor, you understand market cycles and even had the same reply as our younger investor did above when asked the generic question, “what would you do if the market dropped 20%” (your answer: “do nothing or buy more”). Ok, now again the market drops 20%, the same exact decline experienced as our younger friend. Here we’ll help you with the math: a 20% decline on a $4 million portfolio is a loss of eight-hundred-thousand dollars. “$800,000! Enough!” you say. That is a decade’s worth of savings and you have a planned retirement around the corner. You feel angry at your advisor and betrayed by the market. You sell everything and get out, taking the $800,000 loss with no chance of regaining it when the market eventually recovers.

In our two examples we see opposite reactions to identical events. Our younger investor was risk averse (as are most investors), showing a general preference for certainty over uncertainty but able to weigh the choice between risk and reward. Our retiree-to-be investor has become loss averse. Loss aversion is more than the desire to reduce risk; it is an utter disdain for loss. In fact, individuals experiencing loss aversion have been shown to feel the pain of loss more than twice as strongly as any joy felt from an equally sized gain.

Anyone can find themselves in a situation where they become loss averse. This is why it is so important to understand your own expectations and tolerance for risk. It helps to show losses in dollar terms instead of percentages as done above to demonstrate this point. But the personal risk level that is acceptable to you is defined by much more than your age or size of portfolio.

The question we need to answer is: “how far can my portfolio fall before I capitulate and make an emotionally-charged poor decision?”

Your Portfolio Risk Solution

We now have a technology tool that pinpoints your acceptable levels of risk and reward, in both percentages and dollar terms. Based on the Nobel Prize winning work of Daniel Kahneman (author of Thinking, Fast and Slow), our risk questionnaire does far more than ask the unproductive question of “what would you do if the market dropped 20%.” The question we need to answer is: “how far can my portfolio fall before I capitulate and make an emotionally-charged poor decision?”

Here’s how it works:

Take a short quiz that covers portfolio size, top financial goals, and what you’re willing to risk for potential gains. From the questionnaire we’ll pinpoint a personal Risk Number.

We analyze your current investments to generate a Risk Number for your portfolio. Does your portfolio Risk Number match your personal Risk Number? What about your 401(k) or other self-managed accounts? Your entire big-picture portfolio?

We can now discuss how to better align your portfolios to match your personal tolerance for risk. Crucially, we can begin to compare your investment returns not only to a market benchmark, which may not be relevant to your goals, but to your own personal expectations and risk appetite.

By understanding your personal appetite for risk and setting your investment expectations accordingly, you can minimize the situations where you feel the pain of loss aversion tightening its grip. It can help you make smart investment choices and most importantly, allow you to reach your financial goals. If you would like to discover if all of your invested assets accurately reflect your personal risk tolerance, let’s talk.

Perritt Capital Management, Inc. is the registered investment advisor for Windgate Wealth Management accounts
All investments carry some level of risk, including the potential loss of principal invested.